Cotton Option Pricing Based On Weather Indices

Cotton is an important strategic material in people’s livelihood, and also the main raw material of textile industry. Cotton production is so related to people’s daily life that it plays a very important role in the development of the national economy. Having been an important production bases of commodity cotton in middle and lower reaches of Yangtze river, Nantong has a well-developed textile industry. Cotton has been its traditional cash crops, and the industry once became the backbone of local economy. However, in recent years, the frequent occurrence of meteorological disasters caused by global warming, has increased the cost of cotton cultivation, caused sharp fluctuations in cotton price and area, seriously affected the stability of cotton production and farmers’ enthusiasm of cotton planting, as well as the development of local textile industry to a certain extent. Therefore, it is necessary to analyze the meteorological factors affecting cotton production in Nantong City in order to stabilize cotton production and ease contradiction between cotton supply and demand. Meanwhile, appropriate methods should be used to avoid the weather risks it may encounter during the cotton production process.Weather derivatives have developed greatly in foreign countries, since Enron Corp and southwest Florida power company traded the first weather derivatives contracts in the world in August,1996. This successful experience showed that weather derivatives played an important role in transferring weather risks and protecting the interests of buyers. Therefore, this paper introduced the concept of weather derivatives, hoping to provide an effective way to transfer weather risk and to reduce meteorological loss.First, this article analyzed the impact of meteorological factors on cotton production. Based on the experience of previous studies, the paper selected such five meteorological factors as temperature, precipitation, sunshine hours, relative humidity and wind, using gray correlation method to study correlation between these selected conditions and cotton production, associate sequence rankings. The results showed that during the period of1998-2011, meteorological elements correlated with cotton production are:precipitation, temperature, sunshine hours, relative humidity and wind. Therefore, analysis of meteorological factors on cotton yield focused on these three indicators:temperature, precipitation and sunshine, which have greater relevance with cotton production. Secondly, based on the trends analysis of cotton production and various meteorological elements over the years, regression analysis and ADF test methods are used to study the effects of different meteorological factors on cotton yield. The results showed that in growing period, the cotton yield is affected by temperature most, followed by sunshine hours, precipitation significant.Finally, according to the local climate change characteristics and the different impact of meteorological conditions on cotton production, from the perspective of meteorological risk aversion, this article used weather option pricing method to design option contracts based on temperature index, precipitation index and temperature-relative humidity index. In the event of adverse weather conditions, these option contracts can help fanners hedge weather risks, minimize the losses caused by meteorological disasters, improve farmers’ enthusiasm and cotton production.